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The Ultimate Guide to Mutual Funds

Coryanne Hicks

If investing products were desserts, mutual funds would be the mixed berry pie. Like that pie, a mutual fund is a collection of different ingredients -- in this case, different types of investments such as stocks and bonds -- held within the crust of the fund portfolio. When you buy a share of a mutual fund, you're essentially buying a slice of that pie.

Each mutual fund slice is a prorated share of all the investments that make up the fund's pie. So if the fund is 6% Apple (ticker: AAPL) and 3% Coca-Cola Co. ( KO), your slice will also be 6% Apple and 3% Coca-Cola.

You don't own the individual ingredients or underlying investments that make up your mutual fund slice, but rather a share of the entire pie. In other words, if you purchase a share of a fund that invests in Apple and Coca-Cola, you don't own individual stocks of Apple and Coca-Cola themselves but rather a share of the fund.

If you're interested in learning more about investing in mutual funds, this ultimate guide covers the most important things to know:

-- What is a mutual fund?

-- Types of mutual funds.

-- Mutual fund benefits.

-- Passive vs. active mutual funds.

-- Mutual fund fees.

-- How are mutual funds taxed?

-- How to choose a mutual fund.

-- How to buy mutual funds.

-- Exchange-traded funds vs. mutual funds.

-- Selling mutual funds.

What Is a Mutual Fund?

"A mutual fund is actually a legal entity, technically called an investment company," says Jim Rowley, a senior investment strategist with Vanguard Investment Strategy Group. When you buy a mutual fund share, you're buying an ownership stake in the mutual fund company. Hence why mutual fund investors are called shareholders, Rowley says.

The mutual fund company is responsible for pooling investors' money to hire a fund manager who will invest it according to the fund's investment objective. For example, a long-term bond fund may have an investment objective of generating income for its shareholders. Meanwhile, a large-cap growth mutual fund may seek capital appreciation.

Think of the investment objective as what the fund is trying to accomplish and the investment strategy as how the fund plans to get there, says Jacob Gerber, an equity and multiasset investment specialist at Capital Group in Los Angeles.

[READ: 15 of the Best Dividend Stocks to Buy for 2020.]

The investment objective dictates the types of investments the fund manager selects for the fund. With the bond fund, for example, that manager probably invests primarily in longer-term maturity bonds, while the large-cap growth manager invests primarily in large-capitalization companies.

A fund may invest outside of its primary asset class to meet its objective. For example, the long-term bond fund may invest 80% in long-term bonds and 20% in shorter-term bonds or other asset classes. This latitude can be a good thing, Gerber says, because it allows a fund to be more dynamic. But it's also something to watch out for, as it can lead to fund overlap.

A fund's investment strategy will detail the degree to which a fund manager may deviate from his core asset class. The investment objective and investment strategy appear in the fund's prospectus, a legal document fund providers file with the U.S. Securities and Exchange Commission and give to all new investors.

Types of Mutual Funds

With thousands of mutual funds to choose from, whatever your investment taste, chances are there's a fund flavor to match. But all this selection can make it even harder to find the best mutual fund for you.

A good place to start is with the fundamentals. All mutual funds fall into one of six fundamental categories based on what they invest in:

-- Stock funds invest primarily in stocks.

-- Bond funds invest primarily in bonds and other sources of fixed income.

-- Asset allocation funds invest in both stocks and bonds.

-- Money market funds invest in liquid, short-term bonds with the goal of giving investors an alternative to cash.

-- Commodity funds invest in commodity-related companies, such as energy or mining companies.

-- Alternative funds invest in alternative assets outside the stock-bond spectrum and often use complex trading strategies.

Mutual funds typically specialize in a particular area within their broader category, such as long-term bonds or international stocks.

Balanced funds are a type of asset allocation fund that invests in a balance of stocks and bonds, commonly 60% stocks to 40% bonds. Other asset allocation funds also invest in different ratios of stocks to bonds, such as 80% stocks to 20% bonds or 50/50 stocks to bonds, but they're not considered balanced funds. The allocation doesn't change over time. So a 50/50 fund will always be 50% stocks to 50% bonds.

Target-date funds, also called life-cycle funds, on the other hand, change their allocation depending on how close they are to their target date. A target-date fund begins by investing in assets with high potential returns and then gradually becomes more conservative as the target date nears.

Most target-date funds start out investing primarily in stocks. As the target date nears, the fund increases its allocation to fixed income to reduce its risk level. Although conventionally thought of as retirement products, target-date funds can be used to plan for any financial goal with a set time frame.

Mutual Fund Benefits

Instant diversification. A mutual fund may invest in hundreds or even thousands of stocks and bonds, also known as securities. This is one advantage of mutual funds: They provide instant diversification.

"To get reasonable diversification, you should be in (at least) 40 or 50 securities," says Jack Trifts, professor of finance at Bryant University, but this can be challenging -- or even impossible -- to do on your own if you have limited resources.

"A mutual fund allows you to buy a diversified portfolio very easily," Trifts says. Instead of trying to put together your own diversified portfolio of stocks and bonds, you can buy shares in a mutual fund and gain instant exposure to hundreds or thousands of securities. Because each share is prorated across all of the fund's holdings, every share is diversified.

Low minimum investment requirements. While most mutual funds have minimum investment requirements, they tend to be low -- about $1,000 to $2,500. Some funds have lower minimums or will waive them for investors who buy shares within an employer-sponsored retirement plan or sign up for the fund's automatic investment plan.

Professional management. Another benefit of mutual funds is having access to professional management through the fund manager. "Essentially someone else is doing the work for you," by making day-to-day investment decisions for the fund, Trifts says. The degree to which the manager makes those decisions depends on whether the fund is actively or passively managed.

Passive vs. Active Mutual Funds

Actively managed funds have a portfolio manager who actively selects which investments to buy and sell with the goal of outperforming some underlying benchmark, such as a market index.

Comparatively, a passive mutual fund simply aims to match its benchmark, not outperform it. The fund's sole objective is to mirror the performance of the index it tracks by holding the same investments in roughly the same proportion as the index. A passive fund manager doesn't actively select stocks or bonds to buy and sell; hence, passive funds tend to have lower expense ratios than actively managed funds.

Mutual Fund Fees

Mutual funds can have a few different fees. The most recognized mutual fund fee is the expense ratio.

An expense ratio is an annual fee that funds charge shareholders. It's expressed as a percentage of the assets under management and is deducted from the fund each year to cover its costs.

"The way to look at (the expense ratio) is as the ongoing cost of the fund," Rowley says. Mutual funds "have operational costs like any other business," and the expense ratio is used to cover those costs. Because the expense ratio is deducted from a fund's earnings, it reduces the return shareholders receive.

The average expense ratio for an actively managed stock mutual fund is about 0.55%, according to the Investment Company Institute, but it can be more than 2% for specialty or international funds. The average expense ratio for stock index funds is closer to 0.08%.

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Whether you choose to invest in an active or passive mutual fund depends on your preference and philosophy. If you believe a manager can outperform the market, you may be willing to pay the higher cost of an active fund. If you don't believe it's possible to beat the market, or you are more concerned with keeping costs low, a passive index fund may be better.

Another mutual fund fee you may encounter is a sales charge or sales load. Unlike the expense ratio, sales loads are not recurring expenses. Instead, you pay it when you buy (a front-end sales load) or sell (a back-end sales load) the fund.

Not all mutual funds have a sales load charge. In general, it's best to avoid them by choosing no-load mutual funds.

You should also avoid mutual funds that have 12b-1 fees. These are ongoing fees paid to an advisor or firm for marketing the fund. They're capped at 1%, but that's still 1% that could be going into your pocket instead of someone else's.

How Are Mutual Funds Taxed?

Mutual funds are less tax-efficient than exchange-traded funds because investors buy and sell shares through the fund manager. This forces the manager to do more buying and selling within the fund. Since mutual funds are required to distribute capital gains to shareholders, this can create an unexpected tax bill for investors.

If the capital gains are short-term, meaning the fund manager sold an investment that the fund had held for less than 12 months, you'll pay ordinary income rates on the distribution. Long-term capital gains are taxed at the lower capital gains rate.

If your fund pays a dividend, you'll also be taxed on this. Dividends are taxed as ordinary income unless certain IRS qualifications are met. Investors must pay taxes on any dividends received, even if you reinvest those dividends.

To avoid paying taxes on mutual fund distributions in the year they are received, hold the fund in a tax-deferred account, such as a traditional individual retirement account or 401(k). With tax-deferred accounts, you won't pay taxes until you withdraw the money from your account.

How to Choose a Mutual Fund

Your mutual fund choice should depend on why you're investing. Start with your goals so you don't get distracted by funds that may be good investments but won't help you reach your goals. For instance, "you might be looking at a really great stock fund, but if your time horizon is just five years, you shouldn't be in stocks," says Christine Benz, director of personal finance at Morningstar in Chicago. Your investment goal helps determine your time horizon, or how long you have to invest that money, and your risk tolerance.

"Our research at Morningstar indicates that the expense ratio is the single most important data point to consider when selecting funds," Benz says. "Of course, there are poor-performing funds with low costs and strong-performing funds with high costs, but our research suggests that low-expense funds, on average, tend to outperform their peers."

To gauge a fund's performance, Gerber recommends taking the long view -- as in, "the longer the track record, the better." He suggests ignoring one-year returns in favor of 10-year returns for a better idea of how the fund performs over time. Investors should look for managers with good track records of generating returns.

It's easy to get blinded by performance alone, but "the fund with the best recent performance may be taking on more risk than its peers," Benz adds. For this reason, risk measures are another important tool to evaluate mutual funds.

A fund's relative risk level can be measured by comparing its standard deviation, or Sharpe ratio, with that of its peers. Standard deviation measures how much a fund's returns vary relative to its average performance. In other words: How volatile are the fund's returns? A fund with a low standard deviation is less volatile and generally considered less risky.

The Sharpe ratio is used to determine how much risk the fund manager has taken to generate investment returns. A higher Sharpe ratio means the fund manager took less risk to achieve the return. The fund's website generally lists the expense ratio, standard deviation and Sharpe ratio.

Once you've found a fund that meets your objectives, it's time to place a trade.

How to Buy Mutual Funds

Investing in mutual funds works a little differently from other investments. Investors buy and sell mutual funds directly through the fund manager. To purchase shares of a mutual fund, you enter the trade the same way you would for a stock, but it's the fund manager who receives the request and issues your shares.

Mutual funds can be purchased on a per-share basis or in a specified dollar amount. For example, you could buy 100 shares of a fund or you could buy $1,000 of the fund. This is possible because fund managers are willing to sell fractional shares. So your $1,000 could buy you 9.95 shares if the price per share is $100.47.

The price per share is determined by the fund's net asset value. NAV is calculated by adding up the current value of the fund's holdings, subtracting the fund's expenses and then dividing by the number of shares investors hold, called shares outstanding. The fund manager calculates a fund's NAV each trading day at the market close.

Investors receive the next available NAV. So if you place a trade at 11 a.m., you'll receive that day's closing NAV. If you place a trade after market close, you'll get the next day's NAV. You won't know the exact price per share you'll pay for your mutual fund until the next market close.

Exchange-Traded Funds vs. Mutual Funds

This is one of the key features that set exchange-traded funds apart from mutual funds. Structurally, ETFs and mutual funds are similar: Both are investment companies pooling investor money to buy a collection of securities according to an investment objective. Investors own prorated shares of the investments within an ETF just as they do with a mutual fund.

Where ETFs and mutual funds diverge is how they're traded and priced. ETFs trade like stocks, meaning investors can buy or sell ETFs on an exchange throughout the trading day instead of purchasing shares directly through the fund manager. As a result, ETFs can't be bought in specified dollar amounts, because an ETF's price will fluctuate throughout the day based on investor demand.

[Read: 4 Great Benefits of Monthly Dividend ETFs.]

This means you don't have to wait until the market closes for the manager to calculate the NAV to know how much you'll pay for your ETF. You can place a trade and receive the next available market price. The same holds true when you decide to sell an ETF.

Selling Mutual Funds

No matter how great a mutual fund is, you'll eventually need to sell some or all of your shares. Since mutual fund shares are sold directly back to the mutual fund company, selling mutual funds is known as "redeeming."

The process for redeeming shares of a mutual fund is the same as buying: You place a trade for either the specific dollar amount or number of shares you wish to redeem. In return, the fund manager gives you the cash value of your shares based on the next available NAV. And the rest, as they say, is history.

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